Cyprus Rescue Hurts Bloc's Bank Plan

BRUSSELS—European officials have been determined to mend the region's financial market after seeing it torn apart along national lines during the economic crisis. That effort suffered a blow with the radical surgery prescribed for Cyprus's banks as part of March's bailout deal.

The agreement will see large depositors in Cyprus's two big, internationally active banks absorb steep losses. Money transfers to and from the island are now sharply restricted. All told, the deal delivered a wake-up call to regulators, investors and depositors alike about the risk of banks based in European countries with financially stressed governments.

This message could reverberate, analysts say, threatening the economies of Europe's depressed southern rim. Europe's financial plumbing remains clogged, with depositors in Northern Europe wary of sending their money down south, where businesses and consumers are suffocating in an environment of high interest rates.

ENLARGE

If depositors and investors grow even-more nervous about the safety of Southern European banks, the cost of their funding will rise from already high levels and so will their lending rates.

Corporations have taken notice, said
John Grout,
policy and technical director at the Association of Corporate Treasurers.

"What has happened because of Cyprus is that what was already a concern for corporations has become more poignant," he said. "If you have doubts about your bank or that country's banking system, you're bound to respond as hot money."

ENLARGE

EU law allows banks in any country to set up branches in any other country, without the obligation to convert them into subsidiaries.
Bloomberg News

The Cyprus bailout has, to some extent, changed European policy: "Bailing in" depositors and bondholders is now on the table when dealing with Europe's troubled banks. The European Commission, the European Union's executive arm, has proposed that uninsured depositors in failing banks should potentially face losses—but not before 2018. The proposal hasn't been approved by national governments or the European Parliament.

Now a consensus is solidifying behind the idea. European Central Bank President Mario Draghi on Thursday even suggested the date when the plan would come into force should be moved to 2015.

"We're in a world where bail-in is going to be the new normal in the euro area," said
Mujtaba Rahman,
European director at the Eurasia Group. "Rushing to institute a bail-in regime clearly has implications for allocation of capital to the euro-zone periphery."

The commission has been trying to restart the flow of money to the cash-strapped economies of the south. It has warned national regulators about policies that prevent banks from moving capital and deposits freely between their operations in multiple European countries. The U.K. has been a prime target of these warnings, after regulators pressured foreign-owned banks to convert their branches in the U.K., which are regulated by the government where the bank is based, into subsidiaries, which are regulated by the U.K. and have their own capital and liquidity.

EU law allows banks in any country to set up branches in any other country, without the obligation to convert them into subsidiaries.

In 2012, Bank of Cyprus PCL, the largest Cypriot bank, converted its U.K. branch into a subsidiary under pressure from U.K. authorities. Its U.K. deposits were thus formally covered by the U.K. deposit-guarantee program. Given the disaster that then struck Cypriot banks, U.K. authorities may be reluctant to backtrack.

"In the U.K., retail deposit-taking through branches [rather than regulated subsidiaries] is in sharp decline," said
Andrew Bailey,
chief executive of the U.K.'s Prudential Regulation Authority.

His office declined to comment further on the dispute with the commission.

The commission insists it will continue to oppose national policies that seek to limit bank branches or prevent banks from transferring deposits or capital across European borders. It asked national regulators in February to explain any such policies, a prelude to possible legal action by the commission against national governments that don't change course.

While the commission says it has received some pushback from national regulators since the Cyprus bailout, its investigation continues.

"The last thing the European economy needs now is questioning of the single market," a senior EU official said.

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